Scaling Up

April 2016

By Fareem Chagla

Islamic mortgage has emerged as a stronghold within the overall Islamic finance sector and is well equipped to act as a catalyst in the race of ‘Profit against Interest’

An Islamic home financing in essence involves the bank buying a property on behalf of the customer and re-selling the same to them at a profit. It is interesting to see the reasons behind the popularity of this segment within the field of Islamic Finance. The advent of freehold property bought to the fore by markets in the GCC region has been instrumental in driving demand in the region. Coupled is the inherent nature of the mortgage contract, having an underlying tangible asset; it becomes an ideal product offering in the bank’s portfolio allowing little scope of debate on religious grounds, which has otherwise proven a grey area, given varying interpretations.

For the consumer, one of the biggest factors drawing attraction towards this method of financing is the removal of uncertainty around the financing process and having more transparency around the same. With the agreement clearly outlining the profit amount upfront, it is immensely beneficial for clients who seek peace of mind. Besides, unlike conventional finance which invites heavy penalties, translating into an ‘interest on interest’ in the event of a delay in paying an installment, Islamic Finance outlines a fixed fee charged to the client, which is then directed towards charitable activities.

However, this does come at a cost. Some critics have in general underlined the higher costs associated with Islamic Financing, given the increased documentation requirements, which could lead to higher structuring cost compared to available traditional conventional options. Bashar Al Natoor, Global Head of Islamic Finance, Fitch Ratings, opines that the basic differentiator of products between Islamic and conventional Finance, is their Sharia compliance nature and requirements, which has seen increasing customer demand in the past few years. In countries with a mature Islamic finance sector, banks have managed to some extent to reduce such cost, and now there are many Islamic banks and institutions, and even conventional banks, Islamic finance windows, having similar offering, making the overall quality of servicing a key competitive factor.

Popular Islamic home financing options in the UAE are typically based on the ijarah contract and diminishing musharaka. While the Islamic Finance domain is often criticized on the ground of a lack of standardisation, Natoor believes this particular segment, i.e. home financing, is not categorized as very sophisticated bank offering and thus does not necessarily require reinventing, mainly due to its assets backed and based nature.

Current contracts like ijara or diminishing musharakah, amongst others fits well for such product offerings. On the same, Jayesh Soneji, CFA, Member of CFA Society Emirates, believes the scope of innovation limits itself to offering flexibility to the customers. Some areas he points towards are the possibility of prepaying and settling the financing without attracting huge break up cost as is currently the practice and also the possibility to have variable profit rates as part of the options for a customer. As an end user, the customer continues to remain in the dilemma of opting for the Islamic Financing or Conventional Loan route for his home. Soneji adds that while liquidity is drying out from the conventional banking ecosystem, there has been an upsurge in people parking their savings and liquid cash in Islamic Banking channels, which in turn has seen increased liquidity chasing Sharia Compliant Institutions.

In summary, the Islamic Home Financing has within a short period of time established itself as a strong competitor within the mind of the potential home buyer and is well equipped to act as a strong pillar in the race of ‘Profit against Interest’.

Typical contracts centric to Islamic Home Finance include: Murabaha, where the bank acquires the property and sells it back to the buyer with a mark-up. Ijarah, involving the bank typically acquiring the property for the buyer and then leasing it to them with the rent income constitutes the repayment. Diminishing Musharakah, involving the buyer and the bank acquiring the property jointly. The buyer’s share represents the down payment. Subsequently, the bank leases its share of the property to the buyer in return for a rental payment.